FASB: Unrealized Option Benefits Must Go on Income
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November 20, 2003 (PLANSPONSOR.com) - US accounting
rulemakers have decided that companies will have to include
on their income statements any unrealized tax benefits they
have previously gained by issuing stock-option based
compensation.

According to a Dow Jones report, the Norwalk,
Connecticut-based Financial Accounting Standards Board
(FASB) reached the decision at its regular Wednesday
meeting. The move is expected to whip up corporate protests
because the change would pull down earnings. The
International Accounting Standards Board (IASB), which sets
European Union bookkeeping rules, has already decided to
require companies to deduct from profits such tax
shortfalls.

FASB’s Wednesday decision comes as part of a broader
project on stock-based compensation on which FASB and
the IASB have been working together. US companies,
FASB has said previously, will have to expense employee
options starting in 2005, instead of disclosing the
estimated costs in their financial footnotes as current
rules allow (See
FASB: Option Expensing
Begins in 2005
).

As an example, the Dow Jones report said that a company
recognizing $1 billion in stock option expenses and
accruing a deferred tax asset of $350 million based on a
tax rate of 35%, might realize only $150 million in tax
benefits if some of the options become worthless and expire
without being exercised. According to the new rule, the
hypothetical company would have to slash its earnings total
by $200 million, the amount associated with the unrealized
tax benefits.

Currently, option payouts don’t have to count as
expenses in income statements, but count as compensation on
companies’ tax returns boosting cash flows as well as
reducing taxes paid. According to Deutsche Bank analysts,
between 2000 and 2002, companies in the NASDAQ 100 index
got a combined $29-billion boost to cash flow from
operations from the tax deduction. Companies that derived
more than half of their operating cash flows from option
tax benefits during the period included Amazon.com Inc.,
Idec Pharmaceuticals Corp., Broadcom Corp., and Ciena Corp,
the analysts said.

FASB has already heard corporate grumbling about the tax
shortfall issue. Financial Executives International, for
instance, has said in a letter to the FASB that any tax
shortfall associated with employee options – meaning that
the actual tax benefits realized upon the exercise of
options falls below the tax benefits initially expected by
companies – should be deducted from shareholders’ equity in
companies’ balance sheets without flowing through their
profit-and- loss statements. That would represent a
reasonable approach, the leading advocate for corporate
financial chiefs has argued, given that any excess tax
benefits get credited to shareholders’ equity, not to
income.